Econometric Evaluation of Linear Macro-Economic Models

Abstract

Macro-economic models are generally designed to achieve a multiplicity of objectives and correspondingly, they have been evaluated using a vast range of statistical, econometric, economic, political and even aesthetic criteria. However, in so far as they claim to represent economic behaviour, empirical macro-economic systems are certainly open to direct evaluation and testing against data information. The last few years have witnessed a substantial growth in the literature on econometric evaluation techniques, but despite important improvements in formalising evaluation procedures and their increased scope, formidable problems confront any investigation of a high dimensional, non-linear, stochastic, dynamic structure. Since system characteristics are the prime concern of economy-wide models, it might be the case that the validity of every individual component is not essential to adequate overall performance. While this viewpoint is debatable it does draw attention to the need for system evaluation procedures, at which point data limitations pose serious constraints on formal tests. Thus a new "limited information" test of forecast encompassing is proposed, based only on forecasts and requiring no other data from a model's proprietors. The derivation, merits and drawbacks of such a test are presented together with some suggestions for testing entailed relationships and inter-equation feedbacks.